Taxation of Out-of-State Muni Bonds
If you are familiar with investing in muni-bonds then you are aware that they
are attractive because they are exempt from federal taxation.
This preferential treatment allows local governments to obtain funding for
projects at a reduced cost. The concept is to encourage people to invest
in things that aid our society.
In additionl to being exempt from federal income taxes, all
states that have state income taxes exempt from taxation the income derived
from muni-bonds of governments within the state.
This further promotes investors to invest within the state.
Essentially the state is encouraging investments that help the citizens of the state.
(Income derived from muni-bonds issued by governments outside the state is taxed.)
There was the potential of a change on this.
The details are below, but this case did reach the US Supreme Court and that
court ruled to leave the situation as it has been for a very long time.
The remainder of this article is left for historical purposes.
In January 2006 the Kentucky Court of Appeals ruled that the practice of taxing
income derived from muni-bonds issued from outside the state (of Kentucky)
was unconstitutional. In August 2006 the Kentucky Supreme Court denied review
of the case (Davis vs. Department of Revenue; Case No. 2004-CA-001940-MR).
The Kentucky Department of Revenue appealed to the US Supreme Court.
The rules did not change. In such cases it is (or was) prudent
to file a state amended return requesting a refund where taxes were paid on out-of-state
muni-bonds. The request will be denied, but the point is to open the issue before
the statute of limitations closes the return. A tax professional can assist with this.
For California, see the
FTB instructions for filing these claims.